Houston Market and Beyond: 2003

by Aaron Swerdlin

Supply | Rental Rates | Occupancy | Climate-Controlled Premium
 Ownership Trend  | Opportunity | Houston Market at-a-glance

The Houston metropolitan statistical area is the fourth largest in the United States. With more than 450 self-storage properties, the depth of the market and the diversity of the product base make Houston an excellent representation of what is going on within the self-storage industry statewide and nationwide.

Supply
Based on the year-to-year analysis since 1993, the most obvious trend in Houston is a substantial slowdown in new construction, which is consistent with the trend in the industry. 1999 was the most active year ever, relative to new construction, with 46 facilities having been completed. Contrast that with 2002: there will be only 13 new facilities completed. What is even more interesting is that 2001 and 2002 are two of the three slowest years for new construction in Houston in the last 10 years.

In the last ten years 192 new facilities have been built, which means the market has grown by 42% since 1993. By the end of this year there will be 467 facilities open for business. With an average facility size of more than 58,500 square feet, there is more than five and a half square feet of storage space per person, which is one of the reasons we’ve seen the decline in new construction.

For many years the industry supply/demand equilibrium was assumed to be in the neighborhood of three square feet per person. As is the case in Houston, three square feet per person is proving to be substantially below the level that most markets can absorb. Also, as self-storage becomes more mainstream, the demand side of our business grows. In some cases a market can accommodate as much as 11 square feet per person; although markets with this level of supply will tend to be densely populated, in-fill, urban sub-markets where housing costs exceed the market average and household incomes are in the top 25%.

Rental Rates
Although the current Houston market is well occupied, there has been a substantial amount of space to lease during the last three years—a result of the overbuilding. So, banks and developers both have been somewhat bearish. The average market occupancy is almost 86% (including all of the new facilities that aren’t yet leased). Factoring out all the facilities built in 2001 and 2002 from the calculation, the market occupancy is almost 90%. What makes this such a positive indicator for the Houston market is that in the year 2000 alone there was a total of 1,257,000 square feet built. With that much new product entering the market, to be almost 86% occupied means that we’ve absorbed almost all the new space that has been built—more than 2,000,000 square feet in less than two years. With new construction appearing to be low again for 2003 we should finally have a year during which not only new space can be absorbed but also a focus can be made on rental rates.

Occupancy
Although the absorption numbers are trending upwards, it appears that it is happening at the expense of rental rates. Since 1999, non-climate rental rates have grown at a rate of 4.5% per year. However, from 2001 to 2002 the growth is less than 1%. This indicates a very strong rental rate growth for 1999 – 2001 and virtually no rental rate growth for 2002. Climate-controlled space rates have done slightly worse with a 3.9% average annual growth since 1999 but 0% growth for 2002.

Obviously in Houston, the Enron, Dynegy and El Paso layoffs have had some effect, especially in the northwest and southwest areas of the market. Plus, the Compaq-Hewlett Packard merger did result in additional job loss, although most by way of early retirement packages. These economic aberrations won’t have the same all-at-once impact they did this year, so 2003 should be much stronger.

It’s very interesting that the climate-controlled rate failed to keep pace with the non-climate rate relative to the premium. Even more interesting is that this is a trend that we’ve identified for the last three years. This is a very strong indication that the climate-controlled premium has continued to erode. It also means that although the market occupancy is strong, at least some of the absorption has come at the expense of rental rate discounts and the lowering of board rates. And since almost every new facility is comprised of at least 30% climate-controlled space, it’s the newer facilities being hardest hit by the climate- controlled rental rate compression.

In 2000 there was a 62% premium for climate-controlled space. In 2002 the premium has been reduced to 41%. This is still a very healthy premium. But when compared to 2000, the decrease suggests that the overbuilding is going to first be absorbed via a decrease in climate-controlled rates. We could see the premium approach a number as low as 30% if new construction picks up again to the levels of 1999 and 2000.

Climate-Controlled Premium
Because we now have the benefit of several years of statistical data from which we can garner trends, we have studied several common assumptions about the industry. In addition to the supply/demand equilibrium, we wanted to closely look at the long term trend of non-climate rental rates vs. climate-controlled rental rates. And what it shows is that the premium is as much a function of a difference in dollars as it is a premium as a percentage of non-climate. If a non-climate 10x10 leases for $65.00 the premium for the climate-controlled 10x10 is always going to be $30 - $35. So as the rental rate for the non-climate unit increases, so will the climate-controlled unit, but not at the same percentage rate of growth. Rather, it will maintain the $30 - $35 delta.

Ownership Trend
Fifty percent of the market is owned by companies that own four or more properties, up from 41% two years ago. This is an indication that the large operators are still acquiring facilities and also that they represent the majority of the new construction, at least during the last two years. The positive note with such a large percentage of institutional ownership is that those operators tend to aggressively accelerate rental rates, they have a more sophisticated management style and they better educate potential tenants. This management and ownership approach benefits everyone, as it raises the overall expectations of the market.

Opportunity
As is the case across the state and the country, ample new development opportunities do not exist. There are pockets of opportunities, but they are hard to find. Market knowledge is essential because mistakes are easier than ever to make. If a lack of demand or an abundance of competition doesn’t ruin a site, usually land costs will. In the last five years there have been 86 new facilities built. The market cannot absorb another 86 facilities in the next five years, especially since the absorption of the last 86 just turned the corner in the last year.

Although there are only a few areas that are definitively saturated, there are many areas that are going to continue to realize rental rate growth at rates below 4% per year.

One thing that will tempt the market to once again accelerate new construction are interest rates. Interest rates are at a 30-year low, which makes the carry costs of development much less than in years past. But with any new facility being at least two years away from being a candidate for permanent financing, the interest rate risk is still at least moderate. Although no one expects interest rates to increase 3-4% during the next two to three years, it isn’t likely that rates are going to remain as low as they are right now for much more than another year. As soon as the economy begins to rebound, interest rates will slowly creep up to keep inflation from taking hold.

With the stellar economy of 1995 – 2000 and the population growth in Houston, many supply-side mistakes have been well hidden. And with occupancy almost at 86% overall it’s hard to argue that there are too many facilities. However, occupancy alone is not an indicator. Studying the underlying characteristics reveals weaknesses, or at least the vulnerability of the market. The demand continues to absorb the supply in the market. But as the statistics clearly indicate, the demand is still price sensitive over any other factor.

Houston Storage Market at-a-Glance

• Facilities completed in 2002....... 13

• Facilities built in the last 10 years.......  197

• Growth since 1993.......  42%

• Total number of facilities by 2003.......  467

• Average facility size.......  58,500 sq. feet

• Square footage per person.......  > 5.5

• Average market occupancy.......  86%